question

Distinguish between debt and equity financing

answer

Equity financing often means issuing additional shares of common stock to an investor. With more shares of common stock issued and outstanding, the previous stockholders' percentage of ownership decreases. Debt financing means borrowing money and not giving up ownership. Debt financing often comes with strict conditions or covenants in addition to having to pay interest and principal at specified dates.

question

Reasons why common stock is more difficult to value than a bond

answer

PV of stock is equal to the PV of all future dividends... but how many will there be? this means that we still can't compute a value for the stock because we would have to forecast an infinite number of dividends and then discount them all

question

zero growth, constant growth, and non constant growth

answer

1. zero growth - dividend is always the same, stock can be viewed as an ordinary perpetuity with a cash flow equal to D every period 2. constant growth - grows at a steady rate, growing perpetuity, steady/constant growth is a goal of many companies 3. non constant growth - supernormal growth for a finite amount of time, growth rate cannot exceed the required return indefinitely but it could for some number of years

question

dividend yield and capital gains yield dividend yield + capital gains yield = discount rate

answer

dividend yield - a stock's expected cash dividend divided by its current price capital gains yield - dividend growth rate, or the rate at which the value of an investment grows

question

cumulative voting and straight voting

answer

cumulative voting - a shareholder may cast all votes for one member of the board of directors, to permit minority participation straight voting - directors are elected one at a time, a procedure in which a shareholder may cast all votes for each member of the board of directors

question

proxy voting

answer

a grant of authority by a shareholder allowing another individual to vote that shareholder's shares

question

preemptive right (for common stock)

answer

the right to share proportionally in any new stock sold... means that a company that wishes to sell stock must first offer it to the existing stockholders before offering it to the general public to protect their proportionate ownership in the company

question

dividends

answer

payments by a corporation to shareholders, made in either cash or stock 1. not a liability, cannot become bankrupt bc of nonpayment of dividends 2. payment of dividends is not a business expense, not deductible for tax purposes, aka they are paid out of the corporation's aftertax profits 3. dividends received by individual shareholders are taxable

question

common stock

answer

- equity without priority for dividends or in bankruptcy - shareholders elect directors who hire management to carry out their directives - classes of stock vary

question

preferred stock

answer

- stock with dividend priority over common stock, normally with a fixed dividend rate, sometimes without voting rights - have a stated liquidating value - can be considered a debt in disguise, a kind of equity bond

question

cumulative and noncumulative dividends (for preferred stock)

answer

1. cumulative dividends - if preferred dividends are cumulative and are not paid in a particular year, they will be carried forward as an arrearage; usually both accumulated preferred and current preferred 2. noncumulative dividends - may be paid to or withheld from shareholders at the company's discretion

question

primary market and secondary market

answer

primary market - market in which new securities are originally sold to investors to raise money secondary market - market in which previously issued securities are traded among investors

question

dealers and brokers

answer

dealers - agent who buys and sells securities from inventory (cars) broker - agent who arranges security transactions among investors, does not maintain inventory (real estate)

question

NYSE & NASDAQ

answer

The Nasdaq is a dealer's market, wherein market participants are not buying from and selling to one another directly but through a dealer, who, in the case of the Nasdaq, is a market maker. The NYSE is an auction market, wherein individuals are typically buying and selling between one another and there is an auction occurring; that is, the highest bidding price will be matched with the lowest asking price.

question

net present value (NPV)

answer

- the difference between an investment's market value and its cost - how much value is created or added today by undertaking an investment - net present value rule: reject if NPV negative, accept if positive

question

payback period

answer

- the amount of time required for an investment to generate cash flows sufficient to recover its initial cost - packback rule: investment is acceptable if its calculated payback period is less than some respecified number of years - advantages: easy to understand, adjusts for uncertainty of later cash flows, biased toward liquidity - disadvantages: TVM not taken into account, cutoff period isn't exact, ignores cash flows beyond cutoff date, biased against LT projects

question

average accounting return (AAR)

answer

- an investment's average net income divided by its average book value - avg net income/avg book value - AAR rule: a project is acceptable if its AAR return exceeds a target AAR - advantages: easy to calculate, needed info will usually be available - disadvantages: not a true rate of return, TVM ignored, arbitrary benchmark cutoff rate, based on avg net income and book values not cash flows and market values

question

internal rate of return (IRR)

answer

- the discount rate that makes the NPV of an investment zero - IRR rule: an investment is acceptable if the IRR exceeds the required return, it should be rejected otherwise - advantages: closely related to NPV, easy to understand and communicate - disadvantages: may result in multiple answers with nonconventional cash flows, may lead to incorrect decisions in comparisons of mutually exclusive investments

question

profitability index

answer

- PV of an investment's future cash flows divided by its initial cost, also benefit-cost ratio - advantages: closely related to NPV, easy to understand, useful when available investment funds are limited - disadvantages: may lead to incorrect decisions in comparisons of mutually exclusive investments

question

the practice of capital budgeting

answer

true NPV is unknown, companies use multiple criteria for evaluating a proposal, need to take everything into account to make a sound decision

question

stand alone principle

answer

the assumption that evaluation of a project may be based on the project's incremental cash flows

question

incremental cash flows

answer

the difference between a firm's future cash flows with a project and those without the project

question

sunk costs

answer

a cost that has already been incurred and cannot be recouped and therefore should not be considered in an investment

question

opportunity cost

answer

the most valuable alternative that is given up if a particular investment is undertaken

question

erosion

answer

the cash flows of a new project that come at the expense of a firm's existing projects

question

net working capital

answer

normally a project will require that a firm invest in NWC in addition to LT assets... firm supplies NWC at the beginning and recovers it towards the end (similar to a loan)

question

role of financing costs in analyzing a proposed investment

answer

in analyzing a proposed investment, we will not include interest paid or any other financing costs such as dividends or principal repaid, because we are interested in the cash flow generated by the assets of the project

question

understand cash flows used are actual (accrued amounts are not used) and they represent aftertax amounts

answer

only interested in measuring cash flow when it actually occurs, after tax... but thats not the same as net income/accounting profit

question

project cash flow

answer

= project operating cash flow - project change to NWC - project capital spending

question

operating cash flow

answer

= earnings before interest and taxes + depreciation - taxes

question

depreciation = a non cash expense

answer

depreciation tax shield - the tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate... reduces taxes

question

accelerated cost recovery system (ACRS)

answer

depreciation method under US tax law allowing for the accelerated write-off of property under various classifications

question

modified ACRS (MACRS) depreciation

answer

every asset is assigned to a particular class... class establishes its life for tax purposes... once tax life is determined, we compute the depreciation for each year by multiplying the cost of the asset by a fixed percentage

question

scenario analysis and sensitivity analysis

answer

- scenario analysis - determination of what happens to NPV estimates when we ask what-if questions - sensitivity analysis - investigation of what happens to NPV when only one variable is changed

question

managerial options

answer

opportunities that managers can exploit in certain things happen in the future; also known as "real" options

question

contingency planning

answer

taking into account the managerial options implicit in a project, ex: the option to expand, abandon, wait

question

strategic options

answer

options for future, related business products or strategies, ex: research and development

question

capital rationing

answer

the situation that exists if a firm has positive NPV projects but cannot obtain the necessary financing

question

soft rationing

answer

the situation the occurs when units in a business are allocated a certain amount of financing for capital budgeting

question

hard rationing

answer

the situation that occurs when a business cannot raise financing for a project under any circumstances

question

risk and return

answer

the required return depends on the risk of the investment... risk premium

question

portfolio and portfolio weights

answer

portfolio - group of assets such as stocks and bonds held by an investor portfolio weights - percentage composition of a particular holding in a portfolio

question

expected and unexpected returns

answer

expected return - return on a risky asset expected in the future unexpected - uncertain, or risky part

question

systematic and unsystematic risks

answer

systematic risk - a risk that influences a large number of assets; market risk unsystematic risk - affects at most a small number of assets; unique or asset-specific risk

question

principle of diversification

answer

spreading an investment across a number of assets will eliminate some, but not all, of the risk unsystematic risk is essentially eliminated by diversification, so a relatively large portfolio has almost no unsystematic risk

question

total risk = systematic risk + unsystematic risk

answer

.

question

systematic risk principle

answer

the expected return on a risky asset depends only on that asset's systematic risk

question

Beta coefficient

answer

amount of systematic risk present in a particular risky asset relative to that in an average risky asset

question

Security Market Line (SML)

answer

positively sloped straight line displaying the relationship between expected return and beta; after NPV, is arguably the most important concept in modern finance

question

market risk premium

answer

slope of SML, the difference between the expected return on a market portfolio and the risk-free rate

question

capital asset pricing model (CAPM)

answer

equation of the SML showing the relationship between expected return and beta 1. pure TVM as measured by the risk free rate 2. reward for bearing systematic risk as measured by the market risk premium 3. amount of systematic risk as measured by beta

question

cost of capital

answer

the minimum required return on a new investment; what the firm must earn on its capital investment in a project just to break even **** depends primarily on the use of the funds, not the source

question

sources companies use to raise money

answer

1. ST sources such as accounts payable, bank loans, commercial paper 2. LT sources such as bonds, preferred stock, retained earnings, sale of stock

question

calculate cost of debt

answer

- return that lenders require on the firm's debt - for a firm with publicly held debt, the cost of debt can be measured as the yield to maturity on the outstanding debt. the coupon rate is irrelevant - if the firm has no publicly traded debt, then the cost of debt can be measured as the yield to maturity on similarly rated bonds = interest rate * (1 - tax rate)

question

calculate cost of preferred stock

answer

the rate of return that must be earned on the investment of money raised from the sale of preferred stock in order to keep the common stock price unchanged = D/P0 = preferred stock dividends/preferred stock - flotation costs

question

calculate cost of retained earnings

answer

the rate of return that must be earned on the investment of retained earnings in order to keep the common stock price unchanged = (next years dividend/price of common stock) + future growth rate of dividends = %

question

calculate cost of common equity

answer

the rate of return that must be earned on the investment of money raised from the sale of new common stock in order to keep the common stock price unchanged = (next years dividend/(price of common stock*(1 - percentage flotation cost)) + future growth rate of dividends = %

question

calculate weighted average cost of capital (WACC)

answer

- overall required return on the firm as a whole; appropriate discount rate to use for cash flows similar in risk to the overall firm = proportion * cost = weighted cost = (E/V) x Re + (D/V) x Rd x (1-Tc)

question

minimum return required

answer

cost of raising the money, the cost of capital, becomes the minimum desired rate of return for investing money

question

activities that increase, decrease, and do not change cash

answer

increase: increasing LT debt, increasing equity, increasing CL, decreasing CA other than cash, decreasing FA decrease: decreasing LT debt, decreasing equity, decreasing CL, increasing CA other than cash, increasing FA

question

calculate and interpret inventory turnover and inventory period

answer

COGS/avg inventory 365/inventory turnover

question

calculate and interpret receivables turnover and receivables period

answer

credit sales/average accounts receivables 365/receivables turnover

question

calculate and interpret operating cycle

answer

inventory period + receivable turnover

question

calculate and interpret payables turnover and payables period

answer

COGS/average payables 365/payables turnover

question

calculate and interpret cash cycle

answer

operating cycle-accounts payable

question

flexible and restrictive short-term financial policies

answer

1. the size of the firm's investment in current assets (flexible vs restrictive, high vs low)

question

carrying costs and shortage costs

answer

carrying costs = costs that rise with increases in the level of investment in current assets shortage costs = costs that fall with increases in the level of investment in current assets (can be either trading/order costs, or costs related to lack of safety reserves)

question

considerations in determining best ST financial policy

answer

1. cash reserves 2. maturity hedging 3. relative interest rates

question

cash budget

answer

a forecast of cash receipts and disbursements for the next planning period

question

short term borrowing options

answer

1. unsecured loans --> often arrange a line of credit 2. secured loans --> AR financing, inventory loans 3. other sources --> commercial paper, trade credit

question

line of credit

answer

a formal (committed) or informal (noncommittal) prearranged, short term bank loan

question

accounts receivable financing

answer

a secured ST loan that involves either the assignment or factoring of receivables

question

inventory loans

answer

a secured ST loan to purchase inventory 1. blanket inventory lien 2. trust receipt 3. field warehouse financing

question

commercial paper

answer

ST notes issued by large and highly rated firms, interest rate can be low

question

trade credit

answer

increase AP period and can take longer to pay bills, may end up paying a much higher price for what you want to purchase

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